The traditional “income statement” approach suggests that if a company does half the work on a long-term construction project during the current period, they should recognize half of the revenue during that period. To use language that seems to have passed “out of vogue,” it matches revenues with costs incurred during that period to complete the performance obligation.

I’ll admit that the word matching seems to have passed “out of vogue” among standard setters in recent decades. In my work on the revenue recognition project, board members bristled when anyone mentioned the idea of matching. But to be fair, there is a good reason why the principle of matching expenses to revenue (note the direction) is problematic. Unless you have a clear definition of revenue and when it should be recognized, the idea of matching expenses to revenue is much like trying to pin the tail on a moving donkey. This is one of the primary reasons why the boards added revenue recognition to its agenda—to define revenue more carefully and to identify the circumstances (i.e., which changes in assets or liabilities) that would lead to the recognition of revenue.

Interestingly, the FASC letter describes an example of matching revenue to expenses, just the opposite direction of expenses being matched to revenue. Unfortunately, the same tail-and-moving-donkey situation exists here as well.

To what expenses would the revenues be matched?

Should revenue be recognized when cash expenditures are made to obtain framing and roofing materials in a long-term construction project? Is this an expense?

Should revenue be recognized only when these materials are incorporated into the building or ship? Is this an expense? Would it depend on whether the building or ship in progress is the company’s or the customer’s asset?

Should revenue be recognized when a construction company transfers the building to the customer? Is this an expense?

Which expense should drive the recognition of revenue based on the matching principle?

My point here is that both ideas of matching expenses to revenues or matching revenues to expenses are equally vacuous without careful definition and recognition criteria for revenues (in the first case) or expenses (in the second case).

What did the authors have in mind? I am not sure. But this is one example of why comment letters to the boards are sometimes not as useful as they could be. Sometimes they come across as mere opinion without careful analysis. Believing these authors to be smart and careful researchers, I suspect they had something good in mind. So, I would invite them (or anyone else) to respond to my questions. I look forward to reading your comments.

Jeff Wilks

Jeff Wilks is Associate Professor and Kristine V. Vest Fellow at Brigham Young University's Marriott School. He spent several years working as a staff member for the FASB and consultant to the IASB.

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7 comments on “Why Matching Is Out of Vogue”

I believe that the particular remark (matching revenue to the costs incurred) refers to the very similar workings of percentage-of-completion accounting, even if it is not usually expressed that way. Matching and gradual revenue recognition have their problems, but for my own part, I really wonder how useful anyone will find financial statements for firms that get most of their revenue from long-term contracts, if they aren’t allowed to recognize revenue until the last rivet on their skyscraper or cruise ship is attached.

Unfortunately, I cannot speak to what the authors of the FASC comment letter meant, as I’m really not sure. However, I do want to follow up on a comment of yours. You say, both types of matching “are equally vacuous without careful definition and recognition criteria for revenues (in the first case) or expenses (in the second case).”

From this, it sounds like you are saying that matching is sometimes useful. For example, are you saying it makes sense to match expenses to revenues when there are good recognition criteria for revenue?

If so, could you comment some more on why good recognition criteria for revenue (or expenses) would make matching of the opposite flow useful? Is it because good recognition criteria will capture the underlying economics of an exchange and, in so doing, capture the economic reality that inflows of rights are often triggered by an outflow? As I’m typing this, I’m wondering how general these principles are, and if your implied statement about the usefulness of matching is meant to be more limited.

Thoughts?

Disclaimer: The views expressed here are my own and do not represent positions of the Financial Accounting Standards Board. Positions of the FASB are arrived at only after extensive due process and deliberations.

My own take on matching revenues to expenses is as follows:
a) Companies engage in value creating activities.
b) If a company is successful in creating value, income is reported and shareholders’ equity is enhanced. If not, losses are reported.
c) The easiest and most accurate way to assess success is to track all of the cash flows (other than from dealing with owners as owners) from the birth of the company through its liquidation. The net cash flow is the income created by the business. This worked when “companies” were chartered to conduct distinct finite activities, such as an expedition from Europe to the Far East – hence I call this sort of income measurement “Marco Polo accounting.”
d) As companies evolved to have indefinite lives and engage in a myriad of activities that changed over time, people wanted periodic reporting of income. For many companies with short operating cycles, this could be accomplished in a reasonable way by assessing value creation (recognizing revenue) when the performance obligation to the customer is satisfied, which is often at transfer of title.
e) For industries where the creation of value takes many, many years, delaying revenue recognition until the last task is completed does not satisfy the demand for periodic reporting of the success of the business. Thus, accountants tried to measure what portion of the value creation has occurred. In percentage completion accounting, they measure the value creation based on the work done this period relative to the total amount of work to be done.
f) While the percentage completion method has the practical effect of matching revenues to expenses, I think the real underlying goal is to assess how much value has been created this period, and examining expenses incurred happens to be a convenient and somewhat defensible approach when the value creation cycle takes a very long time.

Note that (f) may sound like income measurement takes precedence over the balance sheet or as an endorsement of matching as a primary objective of financial reporting. But notice that I could have stated all of this in a balance sheet perspective – “recognize the work in process inventory at its value in use which includes (a) costs put forth on the project to date, plus (b) the value added by the company to date.” By recording WIP in this manner on the balance sheet, current period income will reflect the value added this period. I believe this is the basic philosophy of IFRS accounting for agricultural assets (e.g., a field of unharvested wheat or a stand of immature timber). Thus, the big chasm between an income vs balance sheet perspective seems to be more of a crack in the sidewalk to me, but that probably should be a topic for a different post.

I agree, Bob…it could be the topic of several posts! Or, better yet, a Round Table, especially if we could get someone willing to defend the balance sheet perspective and someone else willing to champion the income statement perspective. Any volunteers?

Jeffrey asked whether I meant to imply that the matching principle might be useful if revenues or expenses were better defined. My short answer is NO. I just wanted to point out that without careful definitions of one or the other, the matching principle is pretty useless. That alone should make us hesitant to think the matching principle is anything worth espousing. How good is it to know that you’ve matched expenses to the revenues you’ve decided to recognize if the way in which you recognize revenue is arbitrary and does not consistently and faithfully represent changes in some defined asset or liability?

Now, if you pressed me and asked me to choose whether I’d prefer matching revenues to expenses or expenses to revenue (assuming you could define one or the other fairly well), I would go with the former because that maps better into the model of revenue recognition that I personally would support–one in which revenue is recognized from the creation of an asset than can be measured with a threshold level of reliability (meaning that there must be some verifiability or observability of the price that is going to be recognized as revenue). But this idea is best left for another post (coming soon).

Bob, I love the label Marco Polo accounting. I’m definitely going to use that in my teaching! I like your explanation of how practice probably evolved toward methods such as percentage completion accounting. I think the idea was to report the wealth created by the endeavors of a company. As you suggest, a Marco Polo type company is easy to figure out because of its defined life. And companies with short operating cycles can roughly approximate the amount of value created in a period by measuring just the items or service that has been delivered to a customer in that period. Of course, this approach will not include in income the value create by new inventory that may not have been sold but is clearly worth something.

But for companies that have longer operating cycles, it seems that preparers and users evolved to a point at which all were comfortable attempting to measure (with lots of noise) the amount of value created by the company, as long as their was a reliable measure of the price to be received (one of the key purposes of a contract and one of the key requirements in SAB 104) and both parties were expected to follow through with their contract obligations. Is there some sort of general revenue recognition model that could come from this? And does the Boards’ recently proposed model preclude such a general model?

Finally, I agree completely that the discussion about whether a model is more income statement or balance sheet focused is not helpful in this regard. I would love to get two people with opposing views on income statement vs. balance sheet focus to join us for a round table. First, I’d just love to see someone explain what an income statement approach is. How can it even be defined in the absence of assets or liabilities? I’ll stop here. Definitely fodder for a future post!

Even within firms with longer operating cycles the timing pattern for the incurrence of costs versus the generation of revenue can differ widely. For instance, in the case of licensing revenue most of the costs are incurred in developing the patent, but under the current recognition rules revenue is recognized over the life of the licensing contract. In this case using costs incurred as a measure of value created (as Professor Lipe suggests above) may be more problematic than, for instance, in a construction contract.

Many of the recognition issues in recent years have originated in the high tech sector where long-term contracts have become more prevalent. Licensing fees and software prices are prominent examples. In this sector recognition and matching issues are especially complex since the primary expenditure – R&D – is required to be expensed as incurred.

On a related note, I feel that any discussion on the desirability of matching should perhaps also consider the impact of matching on earnings predictability. For instance, in a study on revenue recognition my co-author Rachna Prakash and I find that revenue deferrals (without the deferral of associated costs) impair matching and therefore make earnings less predictable. This complicates the task of both investors and analysts, and our results show that revenue deferrals are associated with significant mispricing and forecast errors (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1316286).

Many of the comment letters on the FASB/IASB’s proposed revenue recognition model also express some concern about enhanced mismatch in the timing of revenue and expense recognition in long-term contracts. My reading of the comment letters suggests that some of the respondents were open to deferring revenues as long as they could also defer the associated expenses (that is, capitalize the associated costs) to better reflect the buildup of economic value. (Since many of these letters are from high tech firms that have R&D as a prominent component of costs, a deferral of associated costs under the current immediate-expensing rules may not be quite that simple.)

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